The Butterfly Option Hedging Strategy is an advanced options technique used to limit risk while maintaining profit potential within a targeted price range. It is particularly popular for range-bound market conditions, low-volatility forecasts, and hedging directional trades with defined loss limits.

This strategy offers a favourable risk-reward profile: small potential loss, defined maximum risk, and decent reward if the underlying settles near a key level by expiry.

What Is a Butterfly Spread?

A Butterfly Spread combines:

• 1 Long ITM (in-the-money) option
• 2 Short ATM (at-the-money) options
• 1 Long OTM (out-of-the-money) option

All with the same expiry. It can be structured using calls or puts.

Example (Call Butterfly):

• Buy 1 Call at Strike A (lower)
• Sell 2 Calls at Strike B (middle)
• Buy 1 Call at Strike C (higher)

Strike prices are equidistant: C – B = B – A

Payoff Profile:

• Maximum profit if price closes at the middle strike (B)
• Defined risk: max loss occurs if price is outside the wings (A or C)
• Breakeven: A + net debit and C − net debit

Strategy Objective

• Hedge an existing directional position
• Generate profit in low-volatility, range-bound markets
• Limit downside while allowing upside potential within a range

Butterfly Hedging Applications

1. Neutral Butterfly for Range Hedge

Use case: Expect market to stay within a narrow range (e.g., pre-event or consolidation)

Setup:

• Use ATM strikes for short legs
• Select 1-week to 1-month expiry
• Ideal for assets like EUR/USD, SPX, NAS100

Hedging Benefit: Provides protection against price stagnation or failed breakouts

2. Directional Butterfly (Broken Wing or Skewed)

Use case: Hedge a long/short position with limited risk, favouring one side

Setup:

• Adjust wing widths (e.g., long strike further away on one side)
• Lower cost, sometimes zero-cost or credit
• Provides asymmetric reward structure

Hedging Benefit: Caps losses while allowing directional bias to play out

3. Overlay on Spot or Futures Position

Use case: You are long EUR/USD, want to protect against range-bound price into ECB decision

Setup:

• Add put butterfly to lock in downside hedge
• Allows long spot trade to remain open but with limited risk exposure

Hedging Benefit: Converts naked long to risk-defined structure while preserving upside

Step-by-Step Butterfly Hedge Example

Example: SPX at 4,500, expecting flat market into expiry

• Buy 1 SPX 4,480 Call
• Sell 2 SPX 4,500 Calls
• Buy 1 SPX 4,520 Call
• Net Cost: $3.00 per share ($300 per spread)

Outcomes:

• Max profit: If SPX closes at 4,500 = $2,000
• Max loss: Limited to $300
• Breakeven: 4,483 and 4,517

Used as Hedge: Protects short-term profit zone while defining risk

Benefits of Butterfly Hedging

• Defined risk and reward
• Cost-efficient compared to long options
• Excellent for hedging trades near expiry or key levels
• Can be adjusted (wings, width, strikes) for different objectives
• Profitable in low-volatility or mean-reversion environments

Risks and Limitations

• Price must settle near middle strike for maximum profit
• Limited profit zone, especially with narrow wings
• Not ideal in high-volatility breakouts
• Requires active management if market shifts direction

When to Use the Butterfly Hedge

• Ahead of major events (FOMC, CPI, earnings)
• During technical consolidations or triangle formations
• To hedge spot or futures positions with low capital
• When IV is high and expected to fall

Conclusion

The Butterfly Option Hedging Strategy provides traders with a low-cost, limited-risk structure ideal for hedging during low-volatility environments or when holding a neutral outlook. Whether you’re managing a directional position or anticipating sideways movement, the butterfly helps protect capital while offering targeted upside.

To master butterfly spreads and integrate them into a full hedging and volatility strategy, enrol in our Trading Courses and gain the skills to trade options with precision, structure, and risk control.